The Obama Administration has stepped forward with its plan to rebuild the troubled U.S. financial system. And the market has responded by retreating. Where did the Administration go wrong with its announcement this week, and what does the economy truly need to start to rebuild liquidity and confidence? In this exclusive interview, economist Alan Madian shares insights on:

The Obama Administration's missteps;

What the banking industry needs to regain its strength;

Economic signs to look for in the months ahead.

Madian is an economist, management consultant, and investment banker. He has provided services as an expert witness, policy advisor, strategy and implementation consultant, and financial advisor for more than 25 years. He has testified on damages and liability in commercial litigation, on the determination of regulated rates of return, and on contractual allocation of risk. Madian has conducted antitrust and market power analyses, testified in antitrust litigation, and served as an advisor to the United States Senate Subcommittee on Antitrust.

Madian also served as economic advisor to a governor of New York. He helps clients to develop new businesses, to acquire and divest companies and divisions, and to assess complex investment decisions, such as nuclear power plant refurbishment. Madian has assisted clients to obtain investment and to privatize government owned enterprises. He has focused on electric utilities, telecommunications, financial services, manufacturing, mining, and international trade.

Madian received his AB degree, Phi Beta Kappa, from the University of California, Berkeley, an MA from Yale, and pursued DPhil studies at Oxford. He served on the faculties of the University of Rochester, The London School of Economics, and NYU. Alan has authored numerous articles and chapters including recent contributions to Electrical World, The Electricity Journal, and The Annals of the American Academy of Arts and Sciences

TOM FIELD: Hi, this is Tom Field, Editorial Director with Information Security Media Group. The topic today is the state of the economy, and we are speaking with Alan Madian, Director with LECG. Alan thanks so much for joining me today.

ALAN MADIAN: My pleasure.

FIELD: Alan, you are an economist, you are a management consultant, you are an investment banker; what do you think of what we saw come down yesterday from Treasury and then how the market reacted to it?

MADIAN: Well I think we have an announcement, which isn't yet a plan. And I think given the promise the President made that there would be some clarity, there was huge disappointment at the lack of clarity. So I am not surprised that we had the kind of reaction we had.

I think we also have an increasing appreciation of the magnitude of the problem. And I think that also led a number of investors to decide that they wanted to exit investments in the banking sector.

FIELD: What do you think that the Obama Administration needs to do? I mean, they are smart people, they can read the tea laves, they certainly can understand the reaction. What do they have to do to pick themselves up from this stumble?

MADIAN: Well it seems to me that I would work on the assumption. I start from the premise that there is probably no one better informed about the magnitude and the intricacy of the problem than Geithner, and there probably isn't a smarter economist focused on this issue than Larry Summers. So the fact that they were not prepared to be more explicit about what the plan is, I think, evidence of a concern that where they are going is a place where Congress is not yet ready to follow them.

I think it is going to be very, very difficult not--I think basically what we have is an insolvency problem, and it is not a liquidity problem. I assume that both Summers and Geithner understand that, and that means that we are going to have, by whatever name, something that involves significant additional government ownership of the major banks, the major money center banks.

FIELD: So the trend that we are seeing toward investment in the banks you are really going to see the federal government own significant pieces of these institutions?

MADIAN: Well, I think what they are doing, what they are proposing is obviously that they are going to go in and do these audits. Now the audits quite properly will focus on the assets on the bank books, and there are huge amount of toxic assets, which are likely enough in and of themselves in a number of cases to render the banks insolvent.

In addition to the toxic assets, there are a whole lot of liabilities, which have not been properly accounted for and particularly the credit default swaps. There are a number of institutions which wrote credit default swaps and which are, if you like, "short" credit default swaps, and to the extent that we have defaults on the underlying assets they will be on the hook for very significant sums.

FIELD: Now Alan, I think we all agree that the economy needs strong banks to recover. What do you think that the banks need to regain the strength and, I guess, the trust that consumers need to have in them?

MADIAN: Well I think there is no question you have to ring fence the toxic assets and the liabilities, and obviously you can't do that without first figuring out exactly what those are and to some extent, the value of those. I mean first you have to identify what they are and then you have to try to value them. It is very, very difficult to value credit default swaps until there is a default. So, there is going to be a degree of uncertainty, and it seems to me because of that uncertainty you are going to have an illliquidity problem where you don't have an insolvency problem.

So to deal with the illliquidity problem you have got to get the assets, those toxic assets and those uncertain liabilities off of the banks books. Having done that you will have solved the problem of the liquidity, but you won't have solved the insolvency problem. So you then have to do something to recapitalize the banks, and I think that is really what the government is planning to do except that they are not, at this point, prepared to say that it is going to result in many of the major money center banks having majority ownership by the government.

Now I think once the government has majority ownership and the balance sheets of the banks have been cleaned up they will obviously want to privatize them just as quickly as possible because the last thing the government wants to do, quite rightly, is be in the banking business beyond its involvement in the banking business in the form of the Federal Reserve and the FDIC.

FIELD: So you are looking at temporary investments -- you think that this is not the U.S. government getting into the banking business permanently.

MADIAN: Well, I would not think it would be permanent, but I think temporary, and temporary might be two or three years and in some instances it might even be a little bit longer depending on things. I would hope that they could be out of the vast majority of their positions within two years, 30 months to the outside.

FIELD: Now Alan, in the banking industry, trust is just such a fundamental element, and the banks rely on consumers trusting that their informational and their financial assets are going to be safe. How big of a concept of trust plays into the economy? Does the economy need this sense of trust from the consumers as well and if so, how do we rebuild it?

MADIAN: Well I think, I suppose that my sense would not be to focus so much on trust. I think you are right about focusing on trust vis-Ã -vis the banks, but I think what we want to do with this, general citizens and the economy, is focus on some degree of price certainty. I mean, I think that what we have at the moment is something in some parts of the country that resembles panic and in other parts of the country something less than panic but somewhere well along the road to dread that prices will continue to erode.

And that's obviously housing prices as a major part of that, but also security prices are of major concern. We have wiped out a huge amount of wealth, something I would think was well in excess of one years GDP in terms of the price erosion and the housing markets and the securities markets and that obliviously has reverberations throughout pension plans and we have increased obligations as a result of decreasing the value of pension plans, the unfunded obligations of states and cities have gone up, etcetera.

So I think what we really have to do is to stop price erosion, and I think that has to be a major focus. And I think that how you do that is a very real question. You don't want to have banks lend long at a low interest rate for housing because in the future interest rates will rise, and you will be hanging the banks out to dry. To the extent that you can, or the government can borrow now at long-term at something in the area of 3%, there may be an argument for lending out those long-term borrowings to the housing sector at 4% or 4.5%, and that would go some way to increasing the demand for housing and the reducing the price erosion in the housing sector.

But I think one also has to recognize that we probably have another 10% or so to go in terms of erosion of housing prices. We are down around 26% now, and I think that by the end of the day we will be down around 35% to 38%.

FIELD: Now let's see, you are saying by the end of day figuratively, but these days that could be literally [laughter].

MADIAN: Well, I hope not.

FIELD: Alan, help in giving us some historic perspective. I mean, we hear from the President even that we are in the toughest times now that we have been in since the Great Depression. But it seems to me that when people say that they are forgetting some pretty serious times that we have had that might not have had the marquee name of Great Depression. Give us some perspective on where we are now versus economic downturns we have had historically.

MADIAN: Well, we have had some fairly serious economic downturns with unemployment rates well into double digits, but this is, I think, since the Great Depression unprecedented in terms of both its impact on liquidity and its impact on the solvency of financial institutions.

And I think there was unprecedented leverage. I mean, there has not been the kind of leverage between the 192's and the recent period, let's say the period from 2003 on, in between. We had with Glass-Steagall there was some, notwithstanding various strategies to avoid the consequences of Glass-Steagall the leverage that was available was significantly less than there was in the most recent period.

I don't think we have had the extent of insolvency across the financial sector previously. I mean, obviously we had something approaching that with the savings and loans in California and Texas back in the 1980s, but it doesn't compare to what we have now. You didn't have the extent of securitization, and you didn't have major financial institutions piling into what were really very, very risky investments without understanding that they had that kind of risk on their books.

FIELD: Now you have spoken a little bit about what the economy needs; what are some of the signs you are going to be looking for in the new administration and for signs that the economy is turning around? And I guess I would also ask, what should banking institutions be looking for as well?

MADIAN: Well, I think that obviously we are facing the possibility of very significant further erosion in mortgage-backed securities, both commercial mortgages and the residential mortgages. As prices decline, we have the negative equity problem, and if people's equity becomes sufficiently negative they may well walk away from the homes leaving them abandoned essentially. That will cause significant additional price erosion, so one of the things that I will be looking for is a slowing of the rate of housing price declines, and I will certainly be monitoring the commercial mortgage default rates.

I think that we are not going to see a turnaround in 2009. I would be absolutely delighted if we saw a turnaround by mid-year 2010. I think we have taken a huge amount of wealth out of the system, and we are obviously in a period where unemployment is rising at a very rapid rate, and that is going to cause further erosion of confidence, and I would think that we are going to have significant erosion demand for the next five to eight quarters.

FIELD: So we've got eight bank CEO's appearing before Congress today, apparently riding taxis and trains and not taking private planes [laugher]. Is it going to be a long day for these gentlemen?

MADIAN: Oh I would think so. But I would think in a sense beating them up about compensation is really a sideshow. I mean, it is important that they get the message that the public is very, very disturbed, and it is important they get the message from the Congress that there is no way that the Congress is going to appropriate more money for them unless they somehow win back some level of public trust.

But I think the essential issue is really to get the bad assets off of the books of the banks, and I would not guess that there will be much discussion of that today.

FIELD: Well said. Alan, I appreciate your time and your insight this morning.

About the Author

Field is responsible for all of ISMG's 28 global media properties and its team of journalists. He also helped to develop and lead ISMG's award-winning summit series that has brought together security practitioners and industry influencers from around the world, as well as ISMG's series of exclusive executive roundtables.

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